So — Which Loan Did You Choose? Real Estate Investors Wanna Know

If you’re unsure about what we’re referring to here, just scroll down to the post immediately below. It’s pretty straightforward.

Let’s skip to the chase here, ‘cuz it’s Friday night, and I’ve got some studyin’ to do. Takin’ care of my periodic requirement for continuing education. It’s an entirely worthless endeavor, but the state has made it abundantly clear they disagree with my assessment. :) To that end, I’m playin’ their game like a good licensee, pretending their silly ‘education’ is worth more than a used Snickers Bar. Boy, did I wander off the reservation with that crud, or what?

Anywho, what loan did you choose? Here’s the bottom line for all three of ‘em. All figures are the for 5 year holding period. And yeah, I don’t make mention of the $2,000 difference in points between #1 and the other two loans. It’s not a factor in this analysis, as loans 2 & 3 both require 2 points. Much of the time points do factor in when deciding upon different loans — just not this time.

Here’s a snapshot of the pertinent info.

1. Cash Flow — $9,906 Principal Reduction — $10,305 Total — $20,211

2. Cash Flow — $18,043 Principal Reduction — $12,250 Total — $30,293

3. Cash Flow — $2,839 Principal Reduction — $27,487 Total — $30,326

The investor’s stated primary purpose was Capital Growth. This means they’re not concerned with cash flow, as long as the property pays for itself or better. Put differently, cash flow is irrelevant to this investor, all things being equal. Of course, if he has an option that doesn’t in any way hinder his capital growth rate, his choice would of course be for more rather than less cash flow. And the congregation says, Duh.

The question here is, what loan will best serve his primary goal of capital growth?

One reader, Shel, said to opt for #1, ‘cuz the investor saves $2,000 in points up front. Let’s not poo poo a couple grand, OK? But look at the above numbers. Would you opt to save $2,000 today, knowing you’re giving up 5 times that amount over the holding period? I guess some folks would. I wouldn’t, at least in this scenario.

Options 2 & 3 offer clone like results when cash flow and principal reduction are tallied. (That may be the first time in my life I’ve ever written the word ‘tallied’. Just sayin’…) They both sport 2 points, (and no, Robert, they refused to budge on points.:)). #3 has over $15,000 in additional principal reduction. Is that a relevant factor here? Depends on your point of view. Some would say since capital growth was the goal, who cares about the cash flow. Furthermore, since it’s our client, they already have an abundantly robust Sominex Account. (Cash Reserves) So again, I ask, does it matter how the $30,000+ in cash flow and loan reduction is dispersed?

I dunno. If you’re the investor, are you gonna follow our advice and keep that cash flow liquid, earning whatever paltry interest is available? Or are ya gonna take the ‘spoils of victory’ approach and use it on 260 ‘date’ nights during the holding period? Discipline is called for when using loan #2. The accumulated cash flow must be added into the tax deferred exchange executed at the end of the 5 years. What’s the big deal you ask? Excellent question grasshopper breath. (Loved watchin’ Kung Fu.)

At 10% down, exiting the accumulated cash flow from the exchange results in a reduction of, give or take, $180,000 in newly acquired property. If you continue that M.O. for 20 years, you’ll have cost yourself roughly $500-800,000 in net worth at retirement. In terms of monthly retirement income, it means: Your insistence on using cash flow generated by your Purposeful Plan to fund date nights, cost you around $2,500-4,500 in retirement income.

Hope you had fun on those dates.

In my opinion, David, Robert, and Peter chose correctly.

Allow me a couple nitpicky points here, OK? First, always remember the investor’s credo: More is better than less. Sooner is better than later. More, sooner is much mo betta. Second, if you use the cash flow in an analysis as a factor in return, make sure you understand there’s no retirement income to be had from your incredible date night memories. If you know in your heart yer gonna spend cash flow, it’s probably better, in your case, to pick loan #3 every time. At least you’ll know the money’s there, and every dollar used to reduce the loan earned 7%.

And for those who wondered why the analysis didn’t include appreciation, show me where it mattered. If the property lost 10% of its value over the holding period, this analysis wouldn’t have changed a whit. ‘Course, if you thought that was a distinct possibility, then loan #3 would’ve been your only choice due to superior loan reduction. That surely begs the question: If ya thought it was gonna lose value over the 5 year holding period, and you were goin’ for capital growth, why’d ya buy the dang thing in the first place, huh Verne? If it went up 50%, and you knew it was, would you have picked a different loan? Nope. Principal reduction for each loan wouldn’t have changed just ‘cuz the property went up, right? Again, Duh.

See how this goes? This ain’t rocket science, but on the other hand it’s not as easy as it looks either. What’s a great loan for one property, is nearly self destructive for another. Same goes for different investors and their approaches to investing. How’d you like to have ‘saved’ $2,000 up front only to have your tax guy tell you that approach cost you $5 for every buck saved?

Dad taught me early on — Make sure yer puttin’ the emphasis on the right sylLAble. That homespun advice has saved my caboose more times than I’ll probably ever know — or even wanna know.

OK, so why haven’t we talked about your situation? The Boss is outa town on a biz trip back east. I’m available and need a fix. Get a hold of me and we’ll figure which way’s north on your map. Have a spectacular weekend.

10 thoughts on “So — Which Loan Did You Choose? Real Estate Investors Wanna Know

  1. Another Investor

    I lost my trusty 23 year-old HP 12C a few weeks ago so I couldn’t do the math, but purchasing a full percentage point reduction in rate for one point looked like a good deal to me. I like loan option 2, because it gives you more cash flow to pay operating expenses. A reserve account is critical, but I think most of your clients have day jobs and would be in serious trouble with both a job loss and an alligator property. Loan option 3 means you WILL be supporting the property.

    Loan option 2 also offers some equity build up over the holding period. That’s a little wiggle room if a refi at a lower rate is available at the 5 year mark, the value has not increased much, and you decide not to sell.

    In short, loan option 2 maximizes your flexibility and minimizes your risk. And Chris is right – get the seller to pay those points!

    Reply
  2. Chris Lengquist

    Another Investor – I’m just now checking back in because I’ve been busy. But I would say that ultimately, the buyer always pays the points. (Seller could have just sold the property less expensively instead of paying the points.)

    But leverage wise, I do like the seller to pay it. You know that. Jeff I think agrees. (I could be wrong, I’ve never asked.)

    The bottom line is I love the exercise. I just work scenarios through until I find the one that works best for the client. And I KNOW Jeff does that, too.

    Reply
  3. Robert Coté

    The extra $130/mo cash flow in option 2 also makes me more comfortable with maintaining a lower cash reserve thus allowing more capital to be deployed. It is also probably easier to shop the second scenario to lenders with the better cash flow. Third when the time comes to sell (oh, excuse me exercise a purposeful Starker exchange) The books will show the second option throwing off $130 more thus raising the price to other potential investors. I know the last isn’t purely rational but someone looking at the books would see that “extra” cash and well… you know.

    Reply
  4. BawldGuy Post author

    Guys — The buyer pays the points, ‘cuz in this case, though not included in the post, the seller is already paying many thousands of buyer’s costs.

    Just so ya know. :)

    Reply
  5. BawldGuy Post author

    Another good point is getting sellers to pay buyers’ costs these days. Many of the properties we’ve been sellin’ lately are not subject to the buyer’s market, relatively speaking.

    One builder’s product has now sold out in three cities, one city twice in the last 12 months. His projects are so well located, with superior price/rent ratios, and all the other cool factors you like to see, that he’s more or less able to act like it’s a normal market.

    He’s a solid example that not only is real estate local, it’s also very discriminating. Quality in a down market still commands respect from potential suitors with the big picture in mind. His results prove that empirically.

    Reply
  6. BawldGuy Post author

    Yeah, Dad said much the same thing. He added though, that it makes sense to know how many $’s those %’s turned out to be. :)

    In this case it was trading in $1 bills for $5′s. Works for me. :)

    Reply

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